Fiscal Policy: Austerity vs. Stimulus

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Transcript Fiscal Policy: Austerity vs. Stimulus

Fiscal Policy:
Austerity vs. Stimulus
Jeffrey Frankel
Harpel Professor of Capital Formation and Growth
Senior Executive Fellows, April 22, 2014
Austerity vs. Stimulus
• Fiscal stimulus or expansion:
– Raise government spending or cut taxes
– to provide short-term economic stimulus,
• for growth & employment.
• Fiscal austerity or contraction:
– cut government spending or raise taxes,
– raising budget surplus (or reducing budget deficit),
• to avoid overheating the economy
• & strengthen long-run debt sustainability.
(Deficit = Δ debt).
Austerity vs. Stimulus, continued
• “What is the best fiscal policy,
Austerity or Stimulus?”
• The question is as foolish
as the question,
“Should a driver turn left or right?”
• It depends where he is in the road.
– Sometimes left is the answer, sometimes right.
Cyclicality of Fiscal Policy
• Keynes favored counter-cyclical policy:
– fiscal stimulus when under conditions like the 1930s
-- depressed income, high unemployment,
low inflation, low interest rates –
to moderate the downturn,
– But fiscal contraction
during boom periods,
to prevent over-heating.
• The boom, not the slump, is the right time for
austerity at the Treasury.” - John Maynard Keynes
(1937) Collected Writings
Cyclicality of Fiscal Policy, continued
• Keynesian policy (“fine tuning”) fell into disfavor
in part because it was hard to get the timing right:
• by the time fiscal stimulus became law,
the recession would be over,
e.g., the Kennedy tax cut,
• passed in1964.
But that is no excuse for pro-cyclical fiscal policy.
Definition of pro-cyclical fiscal policy:
Governments raise spending (or cut taxes) in booms;
and are then forced to retrench in downturns,
thereby exacerbating upswings & downswings.
Cyclicality of Fiscal Policy, continued
• Conspicuously, Greece & other euro members
failed to reduce budget deficits
during years of growth, 2002-08
– and were then forced to cut spending & raise taxes
during the euro debt crisis of 2010-12,
• exacerbating their recessions,
• & even raising Debt/GDP.
• But the United Kingdom did the same,
– despite no euro-constraint forcing austerity in 2010-12.
• And so did the United States !
As one should have expected,
fiscal contraction is contractionary
Source: P.Krugman, 10 May 2012, via R.Portes, May 2013.
Why do leaders fail to take advantage
of boom times to strengthen the budget?
• People don’t see the need to “fix the hole
in the roof when the sun is shining.”
– They do see the mistake
when the storm hits,
• but then it is too late.
• Official forecasts
are over-optimistic
in boom periods,
rationalizing the failure to act
– according to data from 33 countries.
Greece let its deficit rise during the growth years, 2001-08,
despite the 3% of GDP limit set by the Stability & Growth Pact
& then was forced into sharp austerity in 2010-13.
SGP floor
IMF, 2011.
I. Diwan,
PED401, Oct. 2011
Three distinct US fiscal problems
• The long-term problem -- debt unsustainability
– warrants long-term fiscal discipline.
• The medium-term economic problem -slow recovery in aftermath of the 2007-08 financial crisis,
– has warranted demand stimulus,
• not contraction,
• which held back growth, 2011-13.
• The short-term problem has been political:
– Succession of artificial deadlines, threatening disaster.
– Debt ceilings, fiscal cliff, sequester & shutdown.
Fiscal policy
The US does have a long-term debt problem..
Not sustainable
Source: Concord Coalition, spring 2013
The long-term US debt problem, continued
• “Long-term” in the sense that debt/GDP
will rise alarmingly after the 2020s
– unless entitlements are put on a sound footing:
• Social Security & Medicare are due to run big deficits
– as the baby-boomers retire (predictably)
– and the cost of health care rises rapidly (less predictably).
• Definition of debt sustainability:
– regardless the level of the debt, it is sustainable
if the future debt/GDP ratio is forecast to fall indefinitely.
Long-term debt problem, continued
• There is not a short-term problem:
– Far from tiring of absorbing ever-greater levels
of US treasury securities, global investors
continue happily to lend at record-low interest rates (2008-13):
• The US enjoys safe-haven status; the $ enjoys “exorbitant privilege.”
– There is no fiscal crisis. The US is not Greece,
• though we want to be sure not to become Greece in 20 years.
• Indeed the federal budget deficit has come down
• from 10 % of GDP in 2009 to 4 % in 2013 & 3% in 2014.
The US budget deficit shot up in the 200809 recession, but has since fallen by 2/3
(from 10% of GDP to 4% of GDP in 2013)
New CBO estimate:
< 40-year average.
Budget balances
fall in recessions
2008-09 unusual:
1. magnitude
2. earliness of
fiscal contraction
Updated budget projections CBO, Apr. 14, 2014
The evolution of projected future US Debt/GDP ratios
Sequester & other
spending cuts:
Still out there: Coming big deficits
in Social Security & Medicare
Recession +
extension of most
Bush tax cuts
Phony assumption
that Bush tax cuts
would disappear after 2010:
Data: Congressional Budget Office.
Source: How Much Room for Improvement in Long-Term Budget Projections? GoldmanSachs GlobalMacroResearch 1/30/2014
Long-term debt problem, continued
The debt problem is also “long-term” in the sense
that we have known about it a long time.
E.g., when Ronald Reagan, took office:
"For decades we have piled deficit upon deficit,
mortgaging our future and our children's future
for the temporary convenience of the present…
We must act today in order to preserve tomorrow.
And let there be no misunderstanding:
We are going to begin to act, beginning today.”
– Inaugural address, Jan. 20, 1981
The US public discussion is framed as a battle between
conservatives who philosophically believe in strong budgets
& small government, and liberals who do not.
Democrats, Republicans, & the media all use this language.
It is not the right way to characterize the debate.
• (1) The right goal should be budgets that allow
surpluses in booms and deficits in recession.
• (2) The correlation between how loudly an
American politician proclaims a belief in fiscal
conservatism and how likely he is to take genuine
policy steps < 0.
[1] Never mind that small government is classically supposed to be the aim of “liberals,” in the 19th century definition, not “conservatives.”
My point is different: those who call themselves conservatives in practice tend to adopt policies that are the opposite of fiscal conservatism. I call them “illiberal.”
“Republican & Democratic Presidents Have Switched Economic Policies” Milken Inst.Rev. 2003.
Brief US fiscalhistory: The1980s
• The newly elected Reagan complained of inherited debt:
– “Our national debt is approaching $1 trillion. …
A trillion dollars would be a stack of 1,000-$ bills 67 miles high.”
• address to Congress, Feb. 18, 1981.
• Reagan’s actions: sharp tax cuts & rise in defense spending.
• The claim: budget surpluses would result.
• The reality: record deficits that added to the national debt
– a 2nd trillion in his 1st term
– a 3rd trillion in his 2nd term
– a 4th trillion when G.H.W. Bush initially continued the policies.
(“Read my lips, no new taxes.”)
US fiscal history, continued: The 1990s
• The deficits were gradually cut, and then
converted to surpluses by the end of the 1990s.
• How was this accomplished?
– Regime of “Shared Sacrifice” -- 3 key policy events.
• 1990: GHW Bush bravely agreed spending caps, taxes & PAYGO
• 1993: Clinton extended the policy.
• 1998: As surpluses emerged, “Save Social Security 1st.”
– Strong growth in late 1990s.
Fiscal history, continued: The 2000s
• The Shared Sacrifice regime ended
on the day G.W. Bush took office in Jan. 2001.
• He returned to the Reagan policies:
– Large tax cuts
– together with rapid increase in spending (triple Clinton’s)
• not just in military spending (esp. Iraq & Afghanistan),
• but also domestic spending: discretionary + Medicare drugs benefit.
• Just like Reagan, he claimed budget surpluses would result.
• Just like Reagan, the result was record deficits:
– The national debt doubled.
• I.e., GWB incurred more debt than his father + Reagan + 39 predecessors
If there were no political constraints…
• What steps should be taken today
to lock in future fiscal consolidation?
– Not by raising taxes or cutting spending today (new recession);
– nor by promising to do so in a year or two (not credible).
– There are lots of economically sensible proposals
• for spending to eliminate over time,
• more efficient taxes to phase in,
• and “tax expenditures” to phase out.
Federal budget in 2014
Spending 20 ½ % of GDP = Mandatory 12% + discretionary 7% + interest 1%.
Minus tax revenue 17 ½ % of GDP
= budget deficit 3 % of GDP.
The Budget & Economic Outlook,
2014-2024, CBO, 2014, p.15
2/3 of federal spending is mandatory:
social security, medicare, UI
Only 1/3 is
2/3 is
Eliminating all domestic discretionary spending
would not be enough to eliminate the deficit.
How to reduce the budget deficit
Both reduce spending
& raise tax revenue, as we did in the 1990s.
• Discretionary spending.
– Eliminate agricultural subsidies.
– Cut manned space program.
– Trim National Guard
– Close unwanted military bases
– Cut unwanted weapons systems
F-22 Raptor fighter production discontinued (after $67b for 200).
F-35 Joint Strike Fighter? ($600b/10 yrs.)
The C-27J Spartan cargo aircraft? ($567m for 21, direct into storage)
The M1 Abrams tank? (more? Or upgrades?)
Virginia-class submarine? ($2.6 b)
Global Hawk Block 30 drone program?
How to reduce the budget deficit
Both reduce spending & raise tax revenue, continued.
• Tax revenue options
– We could have let G.W. Bush’s
tax cuts expire in 2013.
– Can still curtail expensive & distorting “tax expenditures”
• E.g., Tax-deductibility of mortgage interest,
of health insurance
• Subsidies to oil industry, low tax rate on carried interest, …
– Or launch more ambitious tax reform:
• Introduce a VAT, sales, or consumption tax
• or phase in an energy or carbon tax
– or auctioning of tradable emission permits.
Tax expenditures are huge
Tax expenditures
are far higher than:
social security spending
or military
The Budget & Economic Outlook, 2014-2024, CBO, 2014.
Three tax expenditures to curb
Exclusion of employers’
health contributions
projected at 1.6% of GDP
Mortgage interest deduction
projected at ½ % of GDP.
Preferential treatment
of dividends & cap. gains
projected at 0.6 % of GDP.
The Budget & Economic Outlook, 2014-2024, CBO, 2014.
• Social security
– Raise retirement age – just a little,
• perhaps exempting low-income workers.
– Index benefit growth to chain measure of inflation.
– Further options:
• To please Democrats: Raise the cap on social security taxes.
• To please Republicans: encourage private accounts
– though they contribute nothing to closing the gap.
• Health care
– Encourage hospitals to standardize
around best-practice medicine.
• Pay health providers for “value,” not per medical procedure.
• Standardize around best-practice treatment:
evidence-based (to be facilitated by electronic health records).
E.g., pursue the checklist that minimizes patient infections,
and avoid unnecessary medical tests & procedures.
That is not “death panels.”
• Levers to get providers to follow best practices:
– make Medicare payments conditional
– or offer protection from malpractice litigation.
– Curtail corporate tax-deductibility of health insurance.
Writings by Jeffrey Frankel on fiscal policy:
• On Graduation from Fiscal Procyclicality,” 2013, with C.Végh & G.Vuletin,
J. Developmt. Econ. Summary: "Fiscal Policy in Developing Countries: Escape from Procyclicality," VoxEU, 2011. NBER WP 17619
• "Over-optimism in Forecasts by Official Budget Agencies and Its Implications,"
Oxford Review of Econ. Policy Vol.27, Issue 4, 2011, 536-62.
NBER WP 17239; Summary in NBER Digest, Nov.2011.
• “Snake-Oil Tax Cuts,” 2008, EPI, Briefing Paper 221. HKS RWP 08-056.
• "Responding to Crises," Cato Journal vol.27, no. 2, Spring/Summer, 2007.
• “Republican and Democratic Presidents Have Switched Economic
Policies,” Milken Institute Review 5, no. 1, 2003 QI.
Google “Jeffrey Frankel Harvard” for webpage
blog Blog:
1: More on the US
- a) The long-term debt problem
- b) Did the 2009 fiscal stimulus work?
- c) Procyclical politicians
- d) Partisan stand-offs, 2011-2013
2: Budgets in EM / Developing Countries
3: Balanced Budget Rules
Appendix 1: More on the US
(a) The long-term debt problem..
National debt/GDP is the highest since WWII spike.
Source: CBO, March 2012
Appendix 1: More on the US
(a) The long-term debt problem..
National debt/GDP is the
highest since WWII spike.
Debt / GDP is set to decline over 2014 -18.
Center on Budget and Policy Priorities, Jan.9, 2013
CBPP recommends a further $1.2 tr. in spending cuts & tax rises to stabilize debt out to 2022.
But there is no need for it to hit this year. That would send us back into recession.
Long-term debt problem, continued
Not sustainable
Federal debt ratio
under health cost growth assumptions
Source: How Much Room For Improvement in Long-Term Budget Projections?
Goldman Sachs Global Macro Research 1/30/2014
Data: Congressional Budget Office.
1(b) Did the 2009 fiscal stimulus work?
• Obama was sworn in on January 20, 2009.
– The economy had been in freefall since the Lehman
Bros. failure Sept. 15: GDP fell 8.3 % p.a. in Q4.
– He signed the American Recovery &
Reinvestment Act into law Feb. 17.
• The economic statistics:
– The stock market turned around March 9, 2009.
– The rate of job loss bottomed out in March 2009.
– GDP stopped falling. Recession ended in June.
The stock market turned around immediately
March 9,
GDP stopped falling immediately.
Level of GDP, monthly (Dec.2006-Dec.2013), estimated by Macroeconomic Advisers
The rate of job loss turned around quickly
2009 Jan.20,
Appendix 1(c) Some US politicians have
pursued pro-cyclical (i.e., destabilizing) fiscal policy
1st cycle:
Recession: austerity.
• 1980-81: Reagan’s
speeches pledging action
to reduce the national debt
“beginning today” came
during a period of severe
Boom: profligacy.
•1988: As the economy neared
the peak of the business cycle,
candidate George H.W. Bush
was unconcerned about budget
•“Read my lips,
no new taxes.”
Some US politicians have sought pro-cyclical fiscal policy,
2nd cycle
Recession: austerity.
• 1990:
The first President Bush
summoned the political will
to raise taxes & rein in
spending (PAYGO)
at precisely the wrong
moment -- just as the US
entered another recession.
Boom: profligacy.
• 1993-2000: Despite the most
robust recovery in US history,
– 1993: all Republican congressmen
voted against Clinton’s legislation
to continue PAYGO etc.
– 2000: Even after 7 years of strong
growth, with unemployment < 4%,
G. W. Bush campaigned on tax cuts.
• 2003: After his fiscal expansion had
turned the inherited surpluses into
deficits, GWB went for a 2nd round
of tax cuts & continued a spending
growth rate > Clinton’s.
VP Cheney: “Reagan proved
that deficits don’t matter.”
Some US politicians have sought pro-cyclical fiscal policy, continued
3rd cycle
Recession: austerity.
• 2007-09: Predictably, when the new
worst recession since the Great
Depression hit, Republican congressmen
suddenly re-discovered the evil of deficits,
deciding that retrenchment was urgent.
– They opposed Obama’s initial
fiscal stimulus in February 2009.
• 2011: Subsequently, with a majority
in the House, they blocked further efforts
by Obama when the stimulus ran out,
despite still-high unemployment.
Thus, through 3 cycles,
the efforts at austerity came during recessions,
followed by fiscal expansion
when the economy was already expanding.
The US has its own version of biased forecasts
Official US forecasts
in the 2000s
• White House forecasts were over-optimistic all along.
– OMB in Jan. 2001 forecast rapid rise in tax revenue,
• in effect assuming there would never be a recession.
– Four tricks to justify tax cuts, dating from the 1980s:
• The Magic Asterisk
• Rosy Scenario
• Laffer Hypothesis
• Starve the Beast Hypothesis
The US version of biased forecasts, continued
Official US forecasts
in the 2000s
• Congressional Budget Office forecasts are honest.
– But the Bush Administration adopted new tricks,
– so that “current-law budget” would show future surpluses:
• continuation of Iraq & Afghan wars treated as a surprise each year;
• phony sun-setting of tax cuts…
• In 2001, if the country thought it important enough
to protect any single category against belt-tightening
in the long run -- say military or social security or tax cuts for the rich -it would have been arithmetically possible,
by making the cuts elsewhere.
• But we no longer have the luxury of such choices —
after the effects of mammoth tax cuts (2001 & 2003),
two wars (2001, 2003),
the Medicare prescription drug benefit (2003),
and the severe financial crisis & recession (2008).
• Starting from our current position, each of the 5
components must play a role, along with taxes.
Appendix 1(d):
Repeated partisan stand-offs
in Congress
• In the summer of 2011, Congress
at first refused the usual debt ceiling increase,
– recklessly threatening government default.
– Political dysfunction led S&P to downgrade US bonds from AAA.
“Fiscal cliff” deadline, Jan. 1, 2013.
Sequestration into effect March 1, 2013
Government shutdown, Oct. 1-16, 2013
Debt ceiling, Oct.17, 2013.
The game of “Chicken”
In the 1955 movie
Rebel Without a Cause,
whoever jumps out of
his car first supposedly
“loses” the game.
James Dean does;
but the other guy
miscalculates and
goes over the cliff.
The Republicans may
have miscalculated.
Appendix 2: EM / Developing Countries
Most experience with sovereign debt problems during
our lifetimes arose in developing countries
• Recycling of petrodollars after 1974 – ended in the international debt crisis of 1982
• and the Lost Decade of growth in Latin America.
• Emerging market inflows in the 1990s
– ended in currency crashes:
• Mexico (1994),
• East Asia, Russia (1997-98)
• Turkey, Argentina (2001)…
But Reinhart & Rogoff remind us: sovereign default
is an old story, including among advanced countries –
This Time is Different,
updated in “From Financial Crash to Debt Crisis,” 2010
Sovereign External Debt: 1800-2009
Percent of Countries in Default or Restructuring
Note: Sample size includes all countries, out of a total of sixty six, that were independent states in the given year.
Purcell & Kaufman (1993), Reinhart, Rogoff & Savastano (2003), Suter (1992), and Standard & Poor’s (various years).
Sources: Lindert & Morton (1989), Macdonald (2003),
Emerging Market (EM) countries
learned from the crises of the 1980s & 1990s.
• Some EMs took advantage of the 2002-07
expansion to strengthen their budgets.
• They achieved:
Lower debt levels than advanced economies;
improved credit ratings;
lower sovereign spreads; and
less pro-cyclical fiscal policies.
• Historically, policy in developing countries was pro-cyclical.
• E.g., the correlation between spending & GDP was positive.
Correlations between Gov.t Spending & GDP
Adapted from Kaminsky, Reinhart & Vegh (2004)
Pro-cyclical spending
G always used to be pro-cyclical
for most developing countries.54
Correlations between Government spending & GDP
Frankel, Vegh & Vuletin (2012)
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
The historic role reversal
• Over the last decade some emerging market countries
finally developed countercyclical fiscal policies:
• They took advantage of the boom years 2003-2007
– to run primary budget surpluses and cumulate reserves.
– And so were able to respond to global recession of 2008-09 .
– E.g., Botswana, Chile, China, Korea, & Malaysia.
• Debt levels among rich countries (debt/GDP ratios > 90%)
have reached triple those of emerging markets.
• Some emerging markets have earned credit ratings
higher than some so-called advanced countries.
Cyclicality of Fiscal Policy, continued
During the decade after 2000,
• some Emerging Market governments learned
how to do counter-cyclical fiscal policy,
• while many Advanced Country
politicians forgot,
• turning pro-cyclical instead,
• exacerbating the business cycle.
Country creditworthiness is now inter-shuffled
“Advanced” countries
AAA Germany, UK
AA+ US, France
AA- Japan
ABBB+ Ireland, Italy, Spain
BBB- Iceland
(Formerly) “Developing” countries
Singapore, Hong Kong
Thailand, Botswana
Costa Rica, Jordan
Burkina Faso
S&P ratings, Feb.2012 updated 8/2012
Public finances after 2001
became stronger in EMs
But weaker in advanced economies.
World Economic Outlook, IMF, April 2012
Since 2008 recession, advanced countries have cut spending,
relative to past recoveries; EMs have raised spending
(having been relatively more conservative before 2008)
World Economic Outlook
(WEO) Hopes, Realities, and Risks
IMF, April 2013
How can countries address chronic deficits?
Appendix 3: Budget Balance Rules
• Fiscal rules have been adopted by many countries.
• But the rules are usually violated.
• Europe’s rules have failed (BD < 3% GDP; Debt < 60% GDP)
• Maastricht Criteria & Stability & Growth Pact
– Angela Merkel’s Fiscal Compact may be no better.
• Such rules do not work in the US either:
– Gramm-Rudman-Hollings in late 1980s
– Debt ceiling legislation
– Why?
Countries with Balanced Budget Rules
frequently violate them.
BBR: Balanced
Budget Rules
DR: Debt Rules
ER: Expenditure
International Monetary Fund, 2014
• “Tough” rules like the SGP or BBA are too rigid.
• requiring fiscal contraction when the economy is weak.
• They also lack enforceability:
• Every Euro country violated the SGP.
• They worsen the problem of over-optimistic forecasts.
– E.g., when euro members go above the 3% deficit ceiling,
• they adjust their forecasts, not their policies.
• Better would be “structural” budget targets
with forecasts from independent experts